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Assignment Number 1

Enron Demise- were there warning signals?

Numero Uno Jasleen Kaur (C032) Varchas Bansal (E004) Varun Joshi (E020) Amit Kariwala (E021)

Analysis of Enron Case


Q1 Evaluate Enrons profit, leverage and cash flow performance during the period 19982000. Enron Financial Performance Snapshot
1998 Revenues % growth Total Expenses % growth Net Income % grow101th Net Income Margin % Return on Equity Return on Asset Return on Sales Interest and related charge EBIT Interest Coverage Ratio % Net Operating Income (in $ million) Debt (Affiliates) Debt (Enron Balance Sheet) Debt (Enron and affiliates) Equity (Afficiates) Equity (Enron) Equity (Enron and affiliates) Long term Debt/Equity Cash Flow 1998 Cash flow from Operation Cash flow from investments Cash flow from Financing Total Cash Change Capex Free Cash Flow 1640 -3965 2266 -59 -1905 1999 1228 -3507 2456 177 -2363 2000 4779 -4264 571 1086 -2381 2.395229983 2.25% 550 1582 2.88 1378 703 569.52% 2.25% 31260 54.20% 29882 1999 40112 28.32% 39310 31.55% 893 27.03% 2.23% 9.79 2.68 2.23% 656 1995 3.04 802 8486 7151 15637 11694 9570 21264 0.74 2000 100789 151.27% 98836 151.43% 979 9.63% 0.97% 8.66 1.49 0.97% 838 2482 2.96 1953 9717 8550 18267 13551 11470 25021 0.73

-265

-1135

2398

Profitability

It can be observed from the above financial snapshot that the revenue has increased tremendously (222.42%) from the year 1998 to year 2000. However the income growth is not as proportionate as the increase in revenues. The income has grown by 39%. One of the reasons for a massive spurt in the revenue in the years 1998-2000 is spike in natural gas prices in the USA. Revenue from Natural Gas and other products LOB increased by more than 100% (from 1999-2000). Also, Metals trading contributed to ~10% of 2000 revenues.

Much of the revenue growth was due to the trading activity growth. The increasing trading seems to have diminishing profit margins. Return on equity has seen a decline from 9.79% in 1999 to 8.66% in 2000. Return on assets has also fallen from 2.68% in 1999 to 1.49% in 2000. Net income margin has declined from 2.25% to 0.97%

Leverage
Long term Debt has increased by 16.18% over 1999-2000 period. Long term debt/equity ratio has declined from 0.75 in 1999 to 0.74 in 2000. This represents that company is in strong solvency position. However due to the use of equity method of accounting, the company has not been consolidating the assets and liabilities of affiliates. Therefore the debt to equity ratio calculated is not an adequate representation due to non-consolidation of data. Interest Coverage ratio has remained constant and high over the years which shows that the company has enough profits to cover up it interest expenses. However a closer analysis shows that most of the income is in the form on receivable which will be hopefully recovered at some future date. Moreover, the interest paid by the affiliates is not given and cannot be considered in the calculations.

Cash Flow

Net cash flow from operating activities has increased from $1640 million in 1998 to $4779 million in 2000 due to increase in working capital and other operating activities. Trade receivables has increased over 1999-2000 representing negatively on the cash flow. Due to mark to market revenue recognition, company faces the risk of bad debts in future. Accounts payable have also increased over 1999-2000 period which is represented positively in the cash flow. Free cash flows of the company have increased from ($265) million in 1998 to $2398 million in 2000 which shows that company is in a strong cash position to pursue opportunities which can enhance shareholder value.

Matching the risk with the returns Cost on equity= Risk free + Beta * (Market premium) Accordingly the cost of equity for this case is 12.055% while the return on equity is 8.66% in 2000. This is not an ideal position for the company. Q2. Evaluate Enrons long run financial performance of the company. Does the data reflect Enrons transformation from a pipeline company to a trading company? It is evident from the balance sheet that assets from price risk management activities (current assets) had increased from $2205 million in 1999 to $12018 million in 2000. Also assets from price risk management activities (investments and other assets) increased from $2929 million to $8988 million in 2000. Similarly liabilities from price risk management activities (current liabilities) from $1836 million to $10495 million in 2000. Other liabilities from same have increased from $1587 million in 1999 to $2692 million in 2000. Under cash flow from operations, Net assets from price risk management activities increased from $350 million in 1998 to $(763) million in 2000. This shows that company is moving towards trading company from traditionally being a pipeline company. ROE
(in million USD)

Years Net Profit Equity RoE

1990 202 1856 10.88

1992 306 2547 12.01

1994 453 2880 15.73

1996 584 3723 15.69

1998 703 7048 9.97

2000 979 11470 8.54

As we can observe, RoE has decreased in the years after 1996.

(in million USD)

Years EBIT Sales Operating Margin

1990 481 13165 3.65

1992 620 6325 9.80

1994 716 8984 7.97

1996 690 13289 5.19

1998 1439 31260 4.60

2000 1953 100789 1.94

It can be observed that the operating margin has declined over the years. This is because the sales of Trading business (having low margin) has increased compared to their traditional business (having high margin). PPE/Total Asset

PPE/Total Assets
60% 40% 20% 0% 95 96 97 98 99 2000 52% 44% 39% 36% 32% 18%

Fixed assets like Property, Plant & Equipment increased from $10681 million to $11743 million in 2000 which is a very small amount as compared to a huge increase in price risk assets. Q3. What is your assessment of Enrons earning quality? Enron followed mark to market accounting standards. In this standard, net realized profits for offsetting long and short contracts are recognized right at the time of inception of the contract rather than the conventional approach of recognizing over period of time when the gas is received and delivered. This led to recognition of profits prematurely and failed to account for risk of the other party defaulting. The net profit Margin has reduced from 2.23% in 1999 to 0.97% in 2000 indicating a considerable drop in the margins in the company.
(in million USD)

Net Income CFFO Net income/CFFO

1998 703 1640 0.428659

1999 893 1228 0.727199

2000 979 4779 0.204855

Net income by CFFO has declined. Cash flows from operations should be in line with net income. However the above data indicates that cash flows from operations have seen a huge increase as compared to the net income.

Accounts receivables have also increased from $3030 million in 1999 to $10396 million in 2000. This means that the company is not able to efficiently realize cash from its sales. Equity method of accounting is not a prudent way since assets and liabilities of affiliates are not recorded in a proper manner in the balance sheet of the company. Also only proportionate income of affiliate is mentioned in the balance sheet. Company was using mark to market accounting wherein revenues are recognized at the inception rather than at the delivery of the country. So earnings quality is not adequately reflecting the operations of the country. Q4 Evaluate Enrons financial leverage at the end of 2000
(in $ million) EBIT Interest Dividends on company obligated securities Minority Preference Dividend Preference Dividend before tax EBT Financial Leverage 1998 1582 838 77 118.4615 77 17 26.15385 563.8462 2.80573 1999 1995 656 76 116.9231 135 66 101.5385 1026.462 1.94357 2000 2482 550 77 118.4615 154 83 127.6923 1573.308 1.577568

Financial leverage= EBIT/EBT Degree of financial leverage has decreased 2.80 in 1998 to 1.57 in 2000. This is not a good sign for the company as company will not using more of debt which gives tax advantage to the company. This is not an adequate representation because the assets and liabilities of affiliates are not consolidated with Enron therefore interest liabilities of affiliates are not consolidated with Enron which could have significantly increased the financial leverage. We note that a $21B long position and a $20B short position in the Wholesale division sits on top of total company equity of just $11B. Total assets are $65B. Hedge fund managers know that it is possible to lose money on both long and short positions at the same time. Enron's Wholesale portfolio is about 200% long and 200% short and leverage is increasing.

Q5 Enrons stock price traded around $62.72 per share at the end of April 2001. Do you think Enron was worth that much?
Stock Valuation through DCF method Cost of Equity Cost of Debt: Market capitalization Debt WACC 12.055 8.37 (average yield baa bond) ($83.13 * 1200000000) 10.9531 2000 4779.00 2381.00 2.40 1.00 2.40 2001 2002 2003 2004 2005 2006 Perpetuity 99.756 bn 19.94 bn

(Debt

CFO Capex Free cash flow Discounting factor Discounted FCF

2.64 1.11 2.38

2.90 1.23 2.36 56.52152 19.94 36.58152 30.4846

3.19 1.37 2.34

3.51 1.52 2.32

3.86 1.68 2.30

4.25 1.87 2.28

74.93 1.87 40.16

Enterprise Value Value of Debt Total Value of Equity Price of Share

The estimated price of Enron is $30.48 according to the above DCF analysis. This shows that the stock was over valued,